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The Pauncefort Group is active in a number of different industrial sectors, particularly Engineering. Quentin plc is the group holding company. The Board of Directors of Quentin plc are actively considering a number of projects that might be undertaken by the company or one of its subsidiaries. As a matter of policy, the Board appraises the viability of projects using a discounted cash flow approach.

Quentin plc has 12 million ordinary shares of 50p each in issue out of an authorised ordinary share capital of 15 million. The company has recently paid a dividend of 11p per share on the ordinary shares, which are currently listed at 111p ex div. The dividend growth rate has recently been a little under 11% p.a., and this is expected to continue for the foreseeable future. Extracts from the group balance sheet are as follows:

Quentin plc
£000
Ordinary shares 6,000
Share premium 4,920
Reserves 7,590
Minority interests 1,590
3% irredeemable debentures 4,000
6% redeemable debentures 5,000

Interest on the debentures is payable annually, and both of the current year’s payments are impending. The current market prices for £100 nominal value stock are £33.50 and £105.50 for the 3% and 6% debentures, respectively (both values being cum interest). The 6% debentures are redeemable in ten years’ time at a premium of 2.5%. The effective corporation tax rate for Quentin plc is 35%.

Required:
Calculate the weighted average cost of capital to be used by the company in appraising the viability of its projects, explaining and justifying the approach, and commenting on the results.

A firm is considering two mutually exclusive projects. Both projects cost $300,000 today. The first, the quick-payoff option, produces after-tax cash inflows of $100,000 per year for each of the next four years (and nothing thereafter). The second, the slow-payoff option, produces after-tax cash inflows of $50,000 per year for the next three years, and $300,000 for year four (and nothing thereafter). Assume all cash flows occur at the end of the year, and that the two projects have identical risk. If the discount rate in not known with certainty, which project should the firm take as a function of the discount rate? In other words, give the preferred project for each relevant range of the potential discount rate.

Part A: Describe the following project evaluation processes: NPV, Payback, AAR, IRR. Is any one evaluation process better the others? Why?

Part B: What is the difference between Operating Leverage and Financial Leverage? Also, describe the concepts of DOL, DFL and DCL

Use the following information to prepare a Statement of Cash Flow Accounting Report. The indirect method should be used to find cash flow from operations.

ABC Corporation retails specialty chairs for individuals who like to change sitting positions rather frequently. ABC has been particularly profitable in recent years with the increased amount of time individuals spend at the PC keyboard. The balance sheet accounts for ABC as of December 31, 2006 and December 31, 2005 are presented below. Other information related to 2006 activities is also provided:

Assets 12/31/2006 12/31/2005

Cash $ 220,000 $ 100,000
Marketable Securities 300,000 0
Accounts Receivable 510,000 500,000
Chair Inventory 690,000 610,000
Long-term Investments 200,000 300,000
Plant Assets 1,700,000 1,000,000
Accumulated Depreciation (450,000) (450,000)
Patent 90,000 100,000

Liabilities & Stockholders’ Equity

Accrued Liabilities 825,000 720,000
Notes Payable 295,000 0
Common Stock, $10 Par 800,000 700,000
Additional Paid-in Capital 400,000 250,000
Retained Earnings 940,000 490,000

Net Income for 2006 was $750,000
Cash Dividends of $300,000 were declared and paid in 2006.
A plant asset with an original cost of $500,000 and having a book value of $180,000, was sold in 2006 for $180,000.
A long-term investment was sold in 2006 for $160,000. There were no other transactions affecting long-term investments during 2006.
10,000 shares of common stock were issued in 2006 for $25 per share.

Management of ABC is interested in seeing a statement showing the amount of cash flow from operations, cash flow related to investment activities, and cash flow associated with financing activities.

1. Financial leverage is beneficial only if the firm can employ the borrowed funds to earn a higher rate of return than the interest rate on the borrowed amount. Generally speaking, the higher the financial leverage, the greater the profits at high levels of operating profit.
a) true
b) false

2. How long must one wait (to the nearest year) for an initial investment of $1,000 to triple in value if the investment earns 8% compounded annually?
a) 9
b) 14
c) 22
d) 25

3. How much can be accumulated for retirement if $2,000 is deposited annually, beginning one year from today, and the account earns 9% interest compounded annually for 40 years (rounded up to the nearest 100th dollar)?
a) $87,200
b) $320,950
c) $675,800
d) $802,350

4. What is the YTM of a 7.5 % annual coupon bond, with a $1,000 face value, which matures in 4 years? The market price of the bond is $1,108.32.
a) 4.48%
b) 5.23%
c) 5.76%
d) 6.99%

5. You just bought new furniture for $5,000. The payment is due in 3 years, same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in three years (rounded to the nearest dollar)?
a) $3,969
b) $4,287
c) $4,624
d) $6,299

6. How long must one wait (to the nearest year) for an initial investment of $1,000 to equal $4,500 in value if the investment earns 12% compounded annually?
a) 4 years
b) 6 years
c) 9 years
d) 13 years

7. The present value of cash flows minus initial investments is known as the net present value.
a) true
b) false

8. The expected rate of return given up by investing in a project is known as:
a) break-even point
b) operating leverage
c) internal rate of return
d) opportunity cost of capital

9. Suppose we can invest $4,000 today and receive $6,200 in 4 years. What is the Net Present Value given a 10% expected return?
a) $4,235
b) $4,000
c) $235
d) $2,200

10. The payback rule considers all cash flows that arrive after the payback period.
a) true
b) false

11. The discount rate at which NPV = 0 is known as:
a) degree of operating leverage
b) internal rate of return
c) forward premium
d) Purchasing Power Parity (PPP)

12. The (A) ____________ is the ratio of present value to initial investment, and provides the highest net present value per dollar of investment.
a) forward contract
b) perpetuity
c) plowback ratio
d) profitability index

13. Hard rationing involves limits on available funds imposed by management.
a) true
b) false

14. When performing cash flow analysis, you should discount actual cash flows, not accounting income. Using accounting income, rather than cash flow, could lead to erroneous decisions.
a) true
b) false

15. A stock or bond’s real rate of return factors in:
a) inflation
b) the market premium
c) compound interest
d) the cost of capital

16. The place where the sale of new stock first occurs is known as the:
a) initial public offering
b) over the counter market
c) primary market
d) discount market

17. The movement of stock prices from day to day reflects an upward pattern. Statistically speaking, the movement of stock prices reflect a gradual increase.
a) true
b) false

18. Leverage is using ___________ to magnify the potential return to a firm.
a) profit
b) equity
c) fixed costs
d) interest

19. By decreasing leverage, the firm increases its profit potential, but also increases its risk of failure.
a) true
b) false

Assume the following data for the next three (3) questions:

Company A Fixed Costs = $100,000
Company A Variable Costs per unit = $0.50
Company A price per unit = $3.00

Company B Fixed Costs = $50,000
Company B depreciation = 10 percent
Company B Contribution Margin = $1.50

20. The break-even point for Company A is:
a) 20,000 units
b) 28,571.43 units
c) 33,333.33 units
d) 40,000 units

21. The break-even point for Company B is:
a) 20,000 units
b) 30,000 units
c) 33,333.33 units
d) 40,000 units

22. As compared to Company A, Company B utilizes low operating leverage. This will work against them when sales are low, but will work in their favor when sales are high.
a) true
b) false

23. Generally, if the projected return of a potential project is higher than a firm’s current Weighted Average Cost of Capital (WACC), then the firm should ACCEPT the project. Conversely, they should REJECT the project if the potential return is lower than the expected rate of return on a portfolio of all the firm’s current securities (WACC).
a) true
b) false

24. Other things equal, stock securities are worth more when they are “with-dividend”. Thus when the stock “goes ex,” we would expect the stock price to drop by the amount of the dividend.
a) true
b) false

25. More often than not, the announcement of a stock split results in a rise in the market value of the firm. This is due to the increase in the company’s long and short-term assets.
a) true
b) false

26. You’ve just been informed that you stand to inherit $60,000 in 10 years. You can’t wait that long, and would like to receive the money now. At an interest rate of 8%, how much would you receive?
a) $43,200
b) $18,677
c) $35,481
d) $27,792

27. You have $30,400 to invest, and would like to receive $40,000 in 5 years. What interest rate do you need to accomplish this?
a) 8.23%
b) 6.87%
c) 5.64%
d) 10.56%

28. “The cost of the asset is allocated equally over the periods of an asset’s estimated useful life” describes the concept of:
a) leverage
b) Net Present Value
c) straight-line depreciation
d) divided perpetuities

29. If a stock dividend pays out $4.82, there is a 6.5% growth rate, and the discount rate is 12%, the selling price of the stock will be:
a) $87.64
b) $92.26
c) $97.13
d) $101.57

30. Gains and losses resulting from the sale of securities in an arm’s-length transaction are said to be:
a) liquid
b) intangible
c) with-dividend
d) realized

31. Long-run planning includes production process prioritizing and operational budgeting or profit planning.
a) true
b) false

32. A schedule of all production spending expected to occur during the budget period is known as the selling and administrative expense budget.
a) true
b) false

33. If your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.
a) true
b) false

34. If a firm uses the _________ as an investment criterion, one of the risks it takes is that it may ignore some future cash flows.
a) AAR
b) payback rule
c) IRR
d) NPV

35. Costs that have accrued in the past, which should not be included in your decision to abandon or remain with a strategy, are referred to as:
a) variable costs
b) opportunity costs
c) sunk costs
d) financing costs

A 6 year government bond makes annual coupon payments of 5 percent and offers a yield of 3 percent annually compounded. Suppose that one year later the bond still yields 3 percent.

What return has the bondholder earned over the 12-month period?

Now suppose instead that the bond yield is 2 percent at the end of the year. What return would the bondholder earn in this case?

Propose to launch a new computerized assembly line, which costs $5,000,000, for replacing the existing assembly line. If replace the existing assembly line would result in a before-tax reduction of cash expenses by $1,200,000 per year.

The new assembly line will be fully depreciated by the simplified straight-line method over its five-year depreciable life. It is estimated that the new assembly line will be valueless in five years.

The existing assembly line has five years remaining before it will be fully depreciated and has a book value of $769,680.

If sold today, the company would also receive $769,680 for the existing machine. However, it is estimated that the existing assembly line will be valueless in five years.
If marginal tax bracket is 17% and has a required rate of return of 15%.

1. Before analysing whether B&M’s Company should pay for the new assembly line, please determine which of the following items are incremental cash flows that should be incorporated into a NPV calculation. Please explain:
 the purchase price of the existing assembly line, $1,200,000, ten years ago;
 The cost of research, $23,000, for evaluating different models of the required assembly line.
2. What is the initial outlay associated with this project?
3. What are the annual after-tax cash flows associated with this project, for years 1 through 4 and the terminal cash flow in year 5?
4. Please advise whether your company should launch the new assembly line.